What are we looking for?
Last November, when the financial world still seemed to be caving in, we created a portfolio of stocks using the "magic formula." It's been three months since our last update, so let's check in and see how the portfolio is doing.
Please hold your applause until the end.
The "magic formula" strategy is outlined in The Little Book that Beats the Market , written by U.S. hedge fund manager Joel Greenblatt and published in 2005. The formula aims to find companies that are both profitable and cheap by focusing on two measures: return on capital and earnings yield.
The higher the return on capital - which Mr. Greenblatt defines as pretax operating profit divided by the sum of net working capital and net fixed assets - the more effectively a company is using its capital to generate profit.
The higher the earnings yield - defined as pretax operating profit divided by enterprise value, or the sum of stock and debt - the more attractive the stock is from a valuation standpoint. If you can find a company that's both profitable and cheap, you're getting the best of both worlds.
Last November, we asked the screener at magicformulainvesting.com to generate a list of stocks with a minimum market capitalization of $2-billion (U.S.). Next, we created a hypothetical $1-million portfolio on globeinvestor.com consisting of 20 stocks with an investment of $50,000 each.
How are we doing?
Move over, Warren Buffett. From Nov. 18, 2008, to Sept. 21, 2009, our portfolio soared 72.1 per cent, compared with a 23.9-per-cent gain for the S&P 500 (figures do not include dividends). What's more, all 20 stocks rose, and fully one-quarter posted gains of more than 100 per cent.
What explains such outsized gains? Certainly, our timing was fortuitous.
As you may recall, November was a terrible month for stocks, with many companies driven down to depressed valuations that made them ideal candidates for the magic formula screener. Now that the economy seems to be emerging from recession, their share prices have rebounded strongly.
We'll check back again in a few months to see whether the portfolio continues to outperform the index.